As gold reaches record highs, is bullion still a good investment?

As Warren Buffett once said: “What the wise do in the beginning, fools do in the end.” And despite analysts stating that the bull market in the gold price is far from over, it may not make sense to be as greedy in gold right now. In other words, a more tactical and discerning approach may now be warranted as the risk/reward equation shifts. After all, bulls run out of steam eventually. 

As Adrian Saville, CEO at Cannon Asset Managers, wrote in a recent investment note: “Investors need to be careful with gold – it’s an asset that some investors are fanatical about, which is always a dangerous attribute. Gold is a psychological safe haven, and has little industrial application. This means that its price is driven by behaviour rather than by the fundamentals of supply and demand.” 

For this reason, Cannon Asset Managers favours gold as a permanent – albeit small – component in portfolios. “We currently favour gold miner Pan African Resources, a fantastic business which on average brings gold to the surface at a cash cost of about $950 an ounce. In the current circumstance, with gold above $1,800 an ounce, multiplied by R17/$, this business is doing exceptionally.”

Prudential Investment Managers agree that investing in gold mining companies is tricky. “They are less defensive (being slightly more correlated to equities as an asset class), and require much more in-depth analysis before including them in a portfolio,” says Simon Kendall, a portfolio manager at the firm. These companies (in South Africa and elsewhere), do not have a good track record of being able to sustain their profitability through global economic cycles that bring rising and falling gold prices. This makes the window for investing much narrower than that for gold bullion, and timing the investment more critical, he says. “There have been many periods in history in which the gold miners underperformed the market even as gold bullion outperformed.”

Prudential says between 2000 and 2011, for example, gold equities substantially underperformed gold bullion for several reasons, including: above-inflation increases in operating costs; declining production volumes; capital raising that diluted shareholder value; and a de-rating in their price-earnings ratio premium. They spent capital inefficiently and did not sufficiently benefit from the periods when a weaker rand and higher rand gold price gave them lower input costs and a higher sales price. 

They further state that subsequent to this period, gold mining companies have improved their capital allocation, demonstrating much more discipline in their capital spending and engaging in cost-cutting and other measures to improve efficiencies. Many have also strengthened their balance sheets. These measures have arguably been forced on them by their low market ratings, but have made them more resilient and capable of better exploiting gold price upturns.   

This has created an environment where shareholders can now benefit from the current high US$ gold price and the weak rand, offering the potential for higher corporate profitability and above-average share price gains over time, Kendall says. 

“However, this is also contingent on how much production is curtailed in the national economic shutdowns amid the crisis, and how quickly operations normalise. Another headwind on the horizon could be potential inflation arising from the depreciation of the rand.”

That being said, physical gold bullion itself can still prove to be a good diversifier in a balanced portfolio: Historically, it has demonstrated almost no correlation to equities. So its price will not necessarily fall in a stock market slump, and its value is likely to rise as interest rates fall. At lower levels of interest rates, investors have a lower cost of carry (or opportunity cost), for holding gold.

Industry experts concur that you’ll benefit from the fact that, when market makers change their mind and start selling gold, the downside of owning gold trackers will be relatively muted compared to that of miners. They say now is the time for caution, not exuberance.